What Kind of Derivatives User Is Your Fund?
Rule 18f-4 is somewhat unusual in that it gives management investment companies (including business development companies but excluding money market funds, "Funds") alternative means of complying with its exemption from Sections 18 and 61. A Fund may either:
- Limit the way and extent to which the Fund engages in derivatives transactions (a "Limited Derivatives User"), or
- Adopt a Derivatives Risk Management Program (a "DRM Program") that, among other requirements, limits the Fund's Value-at-Risk ("VaR") relative to an index, its non-derivatives portfolio or its net assets (a "VaR Fund").
Flavors of VaR Funds
Our initial post on the final version of Rule 18f-4 identified four types of Funds classified by the new rule. Three of these Fund types represent different varieties of VaR Funds. Specifically:- Closed-end Funds that have already leveraged themselves by issuing preferred stock in compliance with Section 18 or 61 ("Closed-End w/ Preferred Funds");
- Open-end funds that, as of October 28, 2020, had outstanding shares issued in a public offering and disclosed in their prospectus that they seek to provide investment returns that exceed 200% of the performance or the inverse of the performance of a market index over a predetermined period ("Grandfathered Leveraged/Inverse Funds"); and
- All other VaR Funds.
Putting the 18f-4 Puzzle Together
The following table summarizes when a Fund must adopt a DRM Program, the VaR tests available to each type of VaR Fund and the test's percentage limit on the Fund's VaR.![](http://live-perkins-coie.pantheonsite.io/sites/default/files/Screenshot-2021-04-06-155127.png)
Mostly Vanilla Funds
The SEC staff estimated that, as of September 2020, nearly 80% of Funds could qualify as Limited Derivatives Users. This may be an upper limit if some Fund complexes opt to treat all their Funds as VaR Funds rather than running a separate compliance program for their Limited Derivatives Users. Still, we anticipate that most Funds will try to qualify as Limited Derivatives Users for reasons we'll explain in our next post.Print and share
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